Recent sovereign debt restructurings have been long and protracted. On average, it took 2½ years to complete each of 8 recent restructurings, according to the IMF. Disagreements between creditors have been a principal driver of delays.
Decades ago, to avoid “free riding,” the Paris Club (a group of bilateral lenders) indicated that the private sector should provide “comparable” debt relief if the Paris Club’s official members agreed to reduce the debt of a developing-country borrower. The Paris Club defined comparability of treatment (CoT) according to three dimensions—present-value reduction, duration extension, and nominal debt-service reduction—while allowing flexibility in how private creditors could comply. For example, a private creditor could offer less present-value reduction, but a larger nominal haircut, and that could still be considered comparable.
Recently, the mantra of “CoT” seems to have been adopted generally across creditor groups. But each group appears to have a different definition, typically the one that it prefers! The response from several quarters has been to call for a stricter definition. Some have gone so far as to suggest that every creditor should reduce debt by the same “present value” calculated with a single, stipulated discount rate.
But what if the problem is with the notion of CoT itself? Perhaps CoT, despite sounding appealing, is not the right concept. If so, adopting a stricter definition could actually make matters worse! In this blog post and an associated paper, I discuss two reasons why “strict CoT” may not be the right way forward.
Creditor preferences
Debt comes in many different forms: it is issued in different jurisdictions, in different currencies, using different instruments, at fixed and floating interest rates, with a variety of amortization schedules, indexed to alternative variables in a variety of ways. Innovative contracts, with features like altering payments if environmental or developmental targets are met, are becoming more popular. The wide variety of contracts reflects creditor preferences. Creditors self-select into the ones they like. Those preferences remain relevant if debt is restructured, implying strict CoT would be inefficient. In general, it would make some creditors unhappy relative to others or leave money on the table for the borrower.
But a problem is that countries do not have accurate information on those preferences. Luckily, there are ways forward. Techniques have been designed to elicit and harness this sort of information. Paul Klemperer, a British economist, has devised the “Product-Mix Auction” (PMA) precisely for this situation. Bidders are asked to express preferences over related goods in a single, simultaneous auction involving multiple products.
For instance, a consumer might like apples more than pears or bananas, but be indifferent between three pears and two apples, and between two bananas and one apple. A bidder can submit multiple bids like this across all the products on offer. Employing such bids, the seller then constructs demand curves for each good and the PMA algorithm allocates the goods efficiently across the buyers. The buyers all pay the same price for each good depending on how much the seller wants to sell.
This is not just an academic scheme. The PMA algorithm is used by the Bank of England to sell liquidity to banks via repo contracts with alternative collateral. Tim Willems has suggested using this technique for debt restructuring, where the unfortunate sovereign would offer a set of new instruments, and creditors would express their preferences over the instruments on offer, all relative to a numeraire—say, a standard debt contract such as a plain-vanilla bond.
Following a debt sustainability analysis, the country would signal the aggregate debt relief being sought and the target amortization schedule. The PMA algorithm would allow the country to select a consistent allocation of new debt instruments taking into account creditors’ current debt holdings (akin to a budget constraint) and creditor preferences across the instruments expressed through the bids.
A nice property of the mechanism is that, assuming creditors bid according to their preferences, each creditor should prefer the allocation they obtain relative to that received by any other participant. While creditors may not be happy about providing debt relief, no creditor should envy another. A further advantage is that the technique can incorporate many different types of debt. Indeed, it could be used to foster further innovation, eliciting valuable information on which new innovative contracts might be appealing to creditors.
Debt dilution
A second issue with “strict CoT” is that it would sharpen the incentives for debt dilution. Dilution occurs when a borrower has debt outstanding, there is a chance of a default, and the issuance of new debt reduces the payments to existing creditors in a restructuring. The country benefits from the proceeds of the new issuance, but at least part of the cost is borne by existing creditors, rather than the borrower, creating an incentive to issue. But as creditors anticipate dilution, they charge higher interest rates. The upshot is more and more costly debt, and countries may be worse off compared to a world where they could commit not to issue new debt.
But the incentive to dilute depends on the restructuring regime in place. In the associated paper, I develop a simple theoretical model to illustrate the point. A “strict CoT” rule makes it starkly clear that if new debt is issued, payments to existing creditors will be reduced, cementing the incentives for dilution. In contrast, rules that give some seniority to existing creditors could eliminate dilution incentives, reduce debt levels and interest rates, and raise country welfare.
Conclusion
Creditor preferences and the costs of debt dilution suggest a “strict COT” rule may not be the right way forward. Serious consideration should be given to employing auction technologies to elicit information and achieve faster, more efficient restructuring. In addition, further thought should be given as to how to combine that approach with one that provides seniority to certain types of debt. A question often raised is how such a system would be enforced. A similar issue arises with CoT, as recent proposals to enhance its enforcement highlight. Such efforts would be better directed toward enforcing rules that reduce the incentives for dilution, rather than cementing those incentives within the foundations of the international financial architecture.
